Dutch Securities for American Land Speculation in the Late-Eighteenth Century Draft: August 24, 2012 Rik Frehen Tilburg University K. Geert Rouwenhorst Yale School of Management William N. Goetzmann Yale School of Management Abstract: The end of the 18th century was one of the most innovative periods in the history of securitization. Public markets for mortgage-backed securities are among the most interesting of developments of the period. In The Netherlands, a network of merchant investment bankers developed sophisticated methods for structuring loans based on overseas properties as collateral. In 1793, the Holland Land Company issued two structured notes to purchase millions of acres in Western New York and in 1794 the purchase and development of property in the newly-designated capital city of Washington D.C. was financed by mortgage-backed bonds underwritten by Dutch merchants. These securities raise questions about why investors trusted in the value of overseas property as collateral, and whether the expected rates of return on the instruments were commensurate with their risk. In our analysis, we address these questions by exploring how the early mortgage- backed securities were based on earlier collateralized fixed income instruments in the Dutch market, as well as on other 18th century experiments with collateralization of land. We argue that these innovative securities resulted from an institutional framework that easily accommodated novel fixed income issues, and came on the heels of large gains to market speculation in American debt. Acknowledgements: We would like to thank the librarians at the Stadsarchief in Amsterdam, the Gemeentearchief Rotterdam and the Universiteit van Amsterdam archief for their assistance. We thank Frans Buelens, Ed Glaeser, Oscar Gelderbloom, Kim Osterlinck and participants in the 2011 NBER conference and the Conference on the History of Business and Finance: 2012 at the Toulouse School of Economics for suggestions. I. Introduction Dutch investors have historically played an important role in American finance. The financiers of the American Revolution turned to the Dutch markets for loans to support their war effort and, with Hamilton’s visionary restructuring of the American debt, the Dutch early faith in American promises paid off handsomely. On the heels of their successful financial investment in early U.S. government bonds, Dutch investors in the 1790’s turned their attention – and money – towards the speculative potential of the American land itself. Two of the most important foreign investments in American land development prior to the 19th century were the Dutch loans for the purchase of vast tracts of lots in the newly designated capital city of Washington D.C., and the Holland Land Company loans to purchase, promote, develop and resale large sections of Western New York State, including tracts that included the future Erie canal. Both of these projects were financed by the public issuance of securities that traded on the Dutch capital market. While Washington D.C.’s early development and the operations of the Holland Land Company have both been studied from the perspective of American economic history, few studies have taken the perspective of Dutch investors, and asked what motivated them to invest, what precedents existed for these novel and presumably highly risky ventures, how their investment fared over time and what impact the experience had on future securitizations. The loans offer a rare opportunity to study the process of financial innovation – particularly innovation in the collateralization of real property. In 1793 and 1794, complex several debt securities called “negotiates” were floated in the public capital markets of Amsterdam and Rotterdam to finance the two American land projects. The Washington D.C. loans were made to the American financier James Greenleaf who had earlier been instrumental in arranging U.S. loans on the Dutch market. The Holland Land Company Loans were made to a consortium of leading Dutch merchants, many of whom had been involved in underwriting and pooling U.S. government debt issues in the Dutch market. 1 The land negotiates involved multiple forms of collateral to address different types of risks implicit in the investment, as well as legal and custodial arrangements designed to mitigate fraud and operational failure. In this chapter we examine the terms, conditions, markets and legal framework of these securities. We document their financial precedents and show how they relied on the rapidly evolving financial institutions of the time. Our analysis tells the story of both success and failure. The first land venture capitalized by public securities – the Holland Land Company -- survived for more than half a century and generated substantial economic returns to investors, however a structural reorganization within a decade of its creation was necessary to make it work. The second – the James Greenleaf venture to buy and develop lots in the District of Columbia, ultimately defaulted and the ensuing transatlantic legal dispute over the collateral dragged on for decades. Dutch investor losses arose not only from default, but also from fraudulent manipulation by the Greenleaf and ineffective protection of their rights by the American legal system which significantly reduced recovery from the collateral. We argue that the re-structuring of one set of securities and the failure of the other is due to the path-dependency of Dutch financial innovation and the mis-match between fixed income financing and land speculation. Although the market in late 18th century Holland had apparently become comfortable with mortgage-backed securities, perhaps it should not have been. Equity finance, as opposed to debt finance, might have better served investors. Consistent with this hypothesis, we show how both firms sought to convert to equity-like financing in the years after issuance. The Holland Land Company company used a technique previously employed to provide a residual claim on assets in a closed-end portfolio. Greenleaf and his fellow entrepreneurs in the Washington D.C. enterprise, Robert Morris and John Nicholson, attempted to convert their debt obligations to equity via an initial public offering of equity shares in the North American Land Company shortly after the floatation of the mortgage-backed securities, but were unsuccessful. 2 Our use of historical evidence to examine financial innovation is not new. A number of researchers have pointed out that there is much to learn about mortgage securitization from the historical mortgage market (c.f. White, 2009, Snowden 1995 and 2009, Fishback et. al. 2001, Goetzmann and Newman, 2010), and Gorton (2009) observes that the crisis of 2008 is best understood in the context of a classic banking panic, which a slightly altered institutional structure. The benefit of focusing on the late 18th century Dutch market is that the process of innovation can be clearly traced in historical documents and in public security price quotations. The richness of the historical material allows us to identify specific precedents to an innovation. It also allows us to observe the social and business network in which the innovations appeared and diffused. II. Historical Background Our overview of the 18th century Dutch capital markets is necessarily brief and will focus on the appearance of publicly traded, collateralized financial instruments which is the specific context in which the innovation we study appears. Asset-Backed Securities An important precedent for the American property securities studied in this paper is a class of loans collateralized by the revenue stream of the sale of commodities. An early example of a loan in the Amsterdam market collateralized by a commodity is the 6% 1659 publicly issued security by Johan Deutz to the House of Austria, which was financed by a loan issued at 4%, and collateralized by a monopoly given to Deutz over the product of Austria’s rich quicksilver mines. In effect the loan was a means to secure the monopoly, rather than the principal source of profit by Deutz.1 The demand of commodity security for a loan is not surprising in this example, but the financing of the 1 Barbour p. 109. 3 transaction by Deutz’s loan issue is noteworthy in that Deutz’s credit was enhanced not only by the commodity but his ability as a merchant to benefit from the monopoly and thus reduce the uncertainty of loan repayment. This commodity-backed structure eventually became a standardized financial product in the Amsterdam market. In the early 18th century, Dutch merchants faced a competitive global market for key commodities from the Americas – particularly sugar and coffee. The erosion of the monopoly of the Dutch West Indies Company over Atlantic trade to the Netherlands led to the emergence of independent plantation-owners in Surinam, Essecaibo and Demerary and in certain Caribbean Islands such as St. Eustacia. These independent plantations were financed with innovative securities for which the Deutz Austrian Loan set a clear precedent. From 1753 to 1795 (when the Dutch relinquished sovereignty over their South American plantations), Dutch merchants floated over 240 “plantation loans” in the public markets. These were debt investments in sugar plantations of Dutch South America and the Caribbean that were collateralized by mortgages on the overseas properties (including land, slaves and capital equipment), and the annual commodity production of the plantation. 2 An interesting feature of plantation loans is that the merchants in the commodities trade functioned as financial intermediaries in what we might now call “structured products” which were broadly referred to as negotiaties. The merchant underwrote the issuance of the loans to the public and served as the administrator and servicer, and as the merchant for the commodities on the exchange. His compensation was a commission on sales of the plantation produce while the rest of the sale proceeds were used to service the debt. Van der Voort (1973) notes that the typical interest rate paid by the planters was 5% to 6% and the rate paid to bond holders was fixed as well.